The Guide to Mortgaging a Second Home
Are you looking to purchase a second home? This is an exciting time for you and your family. To ensure that you get the best deal on your mortgage, you’ll want to make sure that you know exactly what type of financing you need. Then, you’ll need to consider your options carefully to get the best combination of rates and terms for your personal situation. If all this seems a bit heady, like the work you had to do when you were shopping for the mortgage on your principal residence, you’re right! Getting a mortgage on a second home requires the same level of care if you want to find the best deal.
Second Mortgage or Mortgage on a Second Home?
The first thing we need to discuss is terminology: If you approach a lender and ask to discuss a second mortgage, it’s a completely different financial product than a mortgage on a second home. You’ll save yourself some time (and perhaps a bit of awkwardness) if you know the difference between the two before you start talking to a lender.
Second Mortgage
A second mortgage is a mortgage that you are adding to the one you already have in place on your home. The amount you can borrow for a second mortgage is based on the equity you have built up in your home. This is the difference between how much you owe on your home from your first mortgage and how much it’s currently worth.
It can be structured in a couple of different ways: a home equity loan or a home equity line of credit (HELOC). In both instances, you are using your home as security for the loan. When you take out a loan, you get the entire amount of money up front. You make regular, structured payments to pay it down over time. With a HELOC, you are given access to funds up to a set limit. You can draw on them when you wish, and you pay interest on the outstanding balance.
Second mortgage rates are generally higher than what you would pay on your first mortgage. The lender is taking a greater risk on these financial products since the first mortgage would get paid out first if you ever had to seek bankruptcy protection or faced foreclosure.
Popular Second Mortgage Products: 90/100/125% Second Mortgages
Home equity loans can be structured in a number of ways, depending on your financial needs and goals. The lender looks at the loan-to-value (LTV) ratio as one of the criteria when making decisions about approving financing. Consider these examples:
90% Second Mortgage: You arrange for financing up to 90% of the value of your home. If your home is currently valued at $250,000 and your existing mortgage is $150,000, you could get a second mortgage of up to $75,000. Current value of your home times 90% ($250,000 x .90 = $225,000) less amount of current mortgage ($150,000) = $75,000.
100% Second Mortgage: The second mortgage is equal to the value of your home. Using the same example of a $250,000 home with a $150,000 mortgage, you can arrange for a second mortgage of up to $100,000.
125% Second Mortgage: This type of mortgage is also called a “no equity mortgage.” This loan option is offered to homeowners looking to refinance their existing mortgage debt to make it more affordable. The lender will advance up to 125% of the value of your home. If your home is worth $250,000, you could borrow up to $312,500 if approved.
Third Mortgage
Since you’re wondering, there is such a thing as a third mortgage. This type of mortgage is even riskier for a lender than a second mortgage, and you would be looking at paying higher interest rates accordingly. The third mortgage would get paid out after the second if you declared bankruptcy or were going through foreclosure, which accounts for the higher level of risk.
Mortgage on a Second Home
Before we start talking about a mortgage on a second home, we should probably clarify exactly what a second home is. Your lender will ask you whether you are looking for financing for an investment property or a second home. You’ll need to know the difference to tell your lender what type of financing you need.
Investment Property Versus Second Home
There are a few significant differences between an investment property and a second home that you need to know.
Investment Property
An investment property is one that isn’t your primary residence that you buy with the goal of generating income. It could be a vacation home that you plan to rent out for the entire year. If you use the vacation home for part of the year, such as the summer months, and rent it out for the rest of the time, it would likely still be considered an investment property.
According to NOLO.com, you can rent out your vacation home for up to 14 days each year and keep the income you receive tax-free. If you decide to rent it out for 15 days or more, special tax rules apply, and you will have to report the income you receive.
Second Home
A second home is a home that you will be living in for part of the year in addition to your primary residence. In many instances, a second home is a vacation home. It doesn’t necessarily have to be a cabin in the woods or a beach house; you can also buy a condo in a city that you visit frequently on business as a second home.
For a property to qualify as a second home, your lender will want to confirm that the home is located close to a vacation area or a resort. It also must be situated within a reasonable driving distance from your main residence, since you will presumably be going there regularly. If you are considering buying a condo in a city you visit on business as your second home, a lender looks at each situation individually. Be prepared to provide some paperwork to show your reasons for out-of-town travel so your lender knows you’ll be occupying the home instead of renting it to others.
You will likely be able to get better rates on a second home mortgage than you would if you were looking at obtaining an investment property mortgage. A second home mortgage will generally include a special rider with some specific conditions that apply to this type of mortgage:
You will occupy and use the property only as your second home.
The second home will be kept available for your use (exclusively) all the time.
You agree not to participate in any type of rental pool or time-sharing arrangement with your second home, and
You won’t rent out your second home or bring in a property management company or another person to manage its day-to-day operation.
Why the Second Home Category Matters for Your Mortgage
Banks base part of their underwriting criteria for lending decisions on the level of risk that a borrower presents when taking out a loan. If you are asking for funds to finance an investment property, you’ll be charged a higher interest rate. The lender sees this type of financing as riskier since you won’t be occupying the property all the time.
The lender will also ask for a higher down payment for an investment property. Be prepared to put down at least 25% of the purchase price to complete the deal. The down payment requirement for a second home is usually about 20%.
You’ll want to be upfront with your lender about your intentions for your second home when you are applying for a mortgage. Let your bank or trust company know exactly what your intentions are so that you can get the right mortgage product. If you aren’t straight with your lender, you could be committing mortgage fraud.
Get the Best Rates on Your Second Home Mortgage
Your first stop when looking for a mortgage on a second home may be the lender that holds the mortgage on your principal residence. That bank may be able to offer you a good rate, but it isn’t necessarily the best rate on a second home.
Don’t hesitate to shop around to find out whether another lender can offer you something better. Not all lenders have a lot of experience with second home lending, and your bank may not be as willing to take a risk as other lenders.
Your credit score really matters when you want to finance a second home. Since you’ll be responsible for two mortgage payments, you’ll need to be financially stable and show the lender that you have a history of meeting your financial obligations as agreed. Order a copy of your credit report and ask that any errors be corrected. If you have any blemishes on your credit history, be prepared to discuss them with your lender. Just be honest about what happened and how you have behaved differently (and more responsibly) since that time.